Standard costing and variance analysis

Standard costing- is a technique which establishes predetermined estimates of the cost of products and then compares these predetermined costs with actual costs as they are incurred.
The predetermined costs are known as standard costs and the difference between standard cost and the actual cost is known as a variance. The process which the total difference between the standard cost and actual cost is broken down into its constituent parts is known as variance analysis.

Types of standards
Basic standards- these are long term standards which would remain unchanged over the years. Their sole use is to show trends over time for items such as material prices, labour rates, and efficiency and to show the effect of changing methods. They cannot be used to highlight current efficiency or inefficiency and would not normally form part of the reporting system.

Ideal standards- these are based on the best possible operating conditions. Such standards therefore assume no machine breakdowns, no material wastage, no stoppage or idle time. It assumes perfect efficiency. Ideal standards are unattainable in practice and therefore not very popular.

Attainable standards- this is a standard based on efficient but not perfect operating conditions. Such a standard would include allowances for normal material losses, realistic allowances for fatigue, machine breakdowns etc. attainable standards provide a tough but realistic target and thus can provide motivation to the management.

Advantages of standard costing
 Standard costing is an example of “management exception”. By studying the variances, management‟s attention is directed towards those items which are not proceeding according to plan.
 The process of setting, revising and monitoring standards encourages re-evaluation of methods and techniques leading to cost reduction

 Standard cost provides a better guide to pricing than historical cost.
 A properly developed standard costing system with full participation and involvement creates a positive cost effective attitude through all levels of management right down to the shop floor.

Disadvantages of standard costing
 It may be expensive and time consuming to install and maintain
 In volatile conditions with rapidly changing methods, rates and prices, standards quickly become out of date and thus lose their control and motivational effects.
 Standards only focus on financial data while other significant non-financial data can also affect efficiency of operations e.g. lead times, customer satisfaction, service quality etc.
Variance analysis
Cost variances are classified as follows:

Direct material cost variance:
1) Material cost variance = (actual price x actual quantity) – (standard price x standard quantity)
2) Material price variance = (actual price – standard price) actual quantity
3) Material usage variance = (actual quantity – standard quantity) x standard price

Direct labour cost variance:
1) Labour cost variance =(actual hours x actual rate) – (standard hours x standard rate)
2) Labour rate variance = (actual rate – standard rate) x actual hours
3) Labour efficiency variance = (actual hours – standard hours) x standard rate

Variable overhead cost variance:
1) Variable overhead variance = (standard variable overhead – actual variable overhead)
2) Variable overhead expenditure variance = (actual production x standard variable OH rate) – actual variable OH
3) Variable OH efficiency variance = ( standard production x standard rate) – actual variable OH

Fixed overhead cost variance:
1) Fixed OH expenditure variance = (actual fixed OH – budgeted fixed OH)
2) Fixed OH volume variance = (budgeted fixed OH – Standard fixed OH)
3) Fixed OH capacity variance = (budgeted fixed OH – Absorbed fixed OH)
4) Fixed OH efficiency variance = (Absorbed fixed OH – Standard fixed OH)

Brian Ltd. produces and sells one product only, the Blob, the standard cost for one unit being as follows:

The fixed overhead included in the standard cost is based on an expected monthly output of 900 units. Fixed production overheads are absorbed on the basis of direct labour hours.

During April 2010 the actual results were as follows:

(a) Calculate price and usage variances for each material
(b) Calculate labour rate and efficiency variances
(c) Calculate the expense variance
(d) Calculate fixed production overhead expenditure and volume variances and then subdivide the volume variance.

Activity 1
Nacomi ltd manufactures one product. The following information was extracted for the month of October 2010.

F indicates a favourable variance while A indicates an adverse variance. Other information:
1. The company uses only one grade of direct material. Direct materials are
purchased in kilograms. Throughout the month, the actual price paid was sh 8.00 above the standard price per kilogram. The standard material cost of the product is sh 720 per unit.
2. The company employs one grade of direct labour. During the month, the actual wage rate paid was sh 68 per hour. Three standard hours are required to produce one unit.
3. Fixed and variable overhead absorption rates are based upon standard hours produced.
4. There were no stocks of materials, work in progress or finished goods held at either the beginning or end of the month. There were no process losses.

Calculate for the month of October 2010:
a. The actual quantity of direct material consumed, in kilogram.
b. The actual price, per kilogram paid for the material.
c. The actual direct labour hours worked.
d. The direct labour hours worked in excess of the standard.

Activity 2
Nyundo Limited manufactures a product whose standard variable cost is given below:

Calculate the following variances in each case stating two possible causes:
(a) Materials usage variance.
(b) Labour rate variance.
(c) Labour efficiency variance.
(d) Variable overhead expenditure variance
(e) Variable overhead efficiency variance.

Recommended texts for further reading
Costing T. Lucey
Costing, An Introduction, Colin Drury Wheldon‟s, “Costing Simplified”
Colin Drury, “Management and Cost Accounting”
Bhabatosh Banerjee, “Cost Accounting Theory and Practice”

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